Los Lobos were a popular Spanish band that shot to fame in the 1980s. Another type of loss on LOBOs has been in the news lately. These are loans taken by many councils and housing associations that are known as ‘Lender Option Buyer Option’ – and were recently the subject of a Channel 4 Dispatches documentary.
What are LOBOs? These are complex loans that often appeared cheaper than the alternatives being offered by the government at the time and hence were attractive to councils and housing associations. LOBOs are not normal loans, they contain complex financial derivatives that used correctly are effective risk management tools, but inappropriately applied contain substantial dangers.
At its simplest, LOBOs can be a bit like a fixed rate loan. However it is unlike a mortgage, in that the bank can cancel it – this is the lender’s option in a LOBO. Why would you agree to this? Price was attractive and if as a council finance officer, you could show you were getting cheaper loans than those on offer by the government – you were a hero. These loans could be for up to 70 years – long beyond the council officer’s pension date.
There are further features. The borrower’s option. The council actually doesn’t have an option; they have sold that to the bank. This could be the option for the bank to cancel the loan or to increase the interest rate paid. This could mean that when interest rates drop yours goes up (a snappily named inverse floater) or it could be an option for a bank to increase the interest rate to what ever it wishes.
Think carefully, would you take out a mortgage than had a teaser rate, but could be cancelled by the bank or they could increase the margin at anytime? This is what many councils, housing associations and universities have done.
If the bank cancels a loan, break costs may have to be paid by the borrower. These can be significant. Channel 4’s Dispatches highlighted a council loan of £25M that had a break cost of £15M. And where a bank can raise interest rates, the borrower has then effectively an unlimited exposure. Vedanta Hedging provided the numerical analysis for this programme.
In the late 1980s at the time Ricky Valance’s Los Lobos was topping the charts, there was a landmark legal case concerning councils and derivatives, between Hammersmith & Fulham councils and Goldman Sachs. Essentially after appeal the ruling was that councils were unable to enter into derivatives and the 137 councils who had done so, were effectively able to walk away from these financial instruments.
Eric Pickles MP in the 2011 Localism Act repealed the inability to enter into derivatives by councils and also introduced the notion of ‘general power of competence’ by councils. However, even if this power is thus far untested, banks were able to effectively enter into derivative contracts with councils through the use of LOBOS.
LOBOs can be viewed as a type of packaged fixed rate loan. Here the customer doesn’t directly enter into a derivative, but the bank enters into a derivative on the customer’s behalf. The end client has the benefits and risks of the derivative, without the required regulatory paperwork or protections. This is exactly what has happened with LOBOs. Banks have neatly sidestepped the inability of councils to enter into derivatives by doing it for them.
What does this mean for banks, councils, housing associations and others that entered LOBOs? There will inevitably be questions as to whether the transactions are valid. There will be examination as to whether borrowers have been negligent and wasted public money and whether advice they may of taken was correct and possibly conflicted due to commission payments. There will also be questions as to whether the LOBOs have been mis-sold by the banks.
There is a long history of derivatives entered into by local authorities and councils ending in disaster. There is on-going litigation in Italy and Germany in this respect. Orange County in California effectively went bankrupt due to derivative speculation. It may be that councils have found themselves in the middle of another well known 1980s show, the Dukes of Hazzard. They certainly have taken huge risks. The effect of LOBOs can be a very real hazard, the price of which is yet to be realised.
Martin Berkeley is FCA Authorised to advise on derivatives and has acted as an expert witness in many derivative cases.